Strengths and Weaknesses in Securities Market Regulation: A Global Analysis

WP/07/259 Strengths and Weaknesses in Securities Market Regulation: A Global Analysis Ana Carvajal and Jennifer Elliott

2007 International Monetary Fund WP/07/259 IMF Working Paper Monetary and Capital Markets Strengths and Weaknesses in Securities Market Regulation: A Global Analysis Prepared by Ana Carvajal and Jennifer Elliott 1 Authorized for distribution by Ceyla Pazarbasioglu November 2007 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper examines the strengths and weaknesses of securities regulatory systems worldwide with a view to a better understanding of common problems and areas of global concern. We found that a consistent theme emerges regarding the lack of ability of regulators to effectively enforce compliance with existing rules and regulation. In many countries, a combination of factors, including insufficient legal authority, a lack of resources, political will and skills, has undermined the regulator s capacity to effectively execute regulation. This weakness is more acute in areas of increased technical complexity such as standards for and supervision of the valuation of assets and risk management practices. JEL Classification Numbers: K22, G18, G24, G28 Keywords: Securities markets; securities markets regulation; Author s E-Mail Address: acarvajal@imf.org; jelliott@imf.org 1 This paper is based on an internal staff note on IOSCO assessment results prepared jointly with Claire Grose and Felice Friedman, both from the Finance and Private Sector Development Unit of the World Bank. We are very grateful to Claire and Felice for their contribution to the work and their additional comments on this paper. The paper benefited from the excellent research assistance of Ivan Guerra and Claudia Jadrijevic, to whom we also extend our thanks. We also thank the IOSCO Implementation Task Force for their helpful comments. We take full responsibility for all errors and omissions contained in this paper.

2 Contents Page I. Introduction...4 II. What is Securities Regulation?...6 III. Data...7 IV. General Findings...11 V. Specific Findings...16 A. Quality of the Regulatory Structure...16 B. Effectveness of Enforcement...19 C. Regulation of Public Issuers...21 D. Regulation of Collective Investment Schemes...23 E. Regulation of Market Intermediaries...26 F. Regulation of Secondary Markets...27 VI. Conclusions...29 Annex 1. Detailed Analysis of the Assessment Data...31 Annex II. Assessed Countries Update...48 Box 1. IOSCO Objectives and Principles of Securities Regulation...8 Tables 1. IOSCO Categories and Countries Grouped by Income...13 2. IOSCO Categories and Countries Grouped by Region...15 Figures 1. Findings 2002 and 2006...12 2. IOSCO Categories and Countries Grouped by Income...14 3. IOSCO Categories and Countries Grouped by Region...16 4. Principles Relating to the Regulator...17 5. Principles for the Enforcement of Securities Regulation...20 6. Principles of Cooperation in Regulation...21 7. Principles for Issuers...23 8. Principles for Collective Investment Schemes...25 9. Principles for Market Intermediaries...27 10. Principles for the Secondary Market...28 11. Principles Relating to the Regulator...31 12. Principles for the Enforcement of Securities Regulation...34 13. Principles of Cooperation in Regulation...36 14. Principles of Self-Regulation...37

3 15. Principles for Issuers...39 16. Principles for Collective Investment Schemes...41 17. Principles for Market Intermediaries...43 18. Principles for the Secondary Market...45 References...49

4 I. INTRODUCTION 1. Securities markets play a crucial role in economic growth and financial stability. The primary purpose of securities markets is to serve as a mechanism for the transformation of savings into financing for the real sector, thus constituting an alternative to bank financing. Markets provide the best (albeit sometimes imperfect) mechanism for asset pricing. Markets are also a mechanism through which risk is transferred and risk exposure diversified which allows firms to unlock capital for new investments. 2 Risk transfer and pricing mechanisms in the market allow financial institutions, such as banks and insurance companies, to manage risk more efficiently; and markets may therefore work as a buffer for disruption of banking system and therefore contribute to financial stability. The more efficient markets are, the better these outcomes are achieved and the greater the contribution to the economy. 2. While the role of securities markets is more meaningful in developed economies, there is evidence of the growing importance of securities markets in emerging market and developing countries. In many emerging market and developing countries, securities markets are beginning to gain a place as a source of financing for the corporate sector, although in most markets this is initially restricted to the larger corporate players. 3 Along with private and public pension funds, collective investment schemes have become important players in many developing and emerging market countries and their demand for suitable investments is driving development. 3. Despite the growing understanding of the role that securities markets play, we find that the systemic importance of securities regulation has been neglected as a topic of academic study. It has been argued, most famously, in remarks by the former Chairman of 2 Richard Herring and Anthony Santomero, 2000, What is Optimal Regulation? (Pennsylvania: Financial Institution Center, University of Pennsylvania). 3 See, for example, Charles Amo Yartey, 2006, The Stock Market and the Financing of Corporate Growth in Africa: the Case of Ghana IMF Working Paper No. 06/201 (Washington: International Monetary Fund), which following on earlier work by Ajit Singh and J. Hamid, 1992, Corporate Financial structures in Developing Countries IFC Technical Paper, No.1 (Washington: International Finance Corporation) uses empirical evidence to show that the stock market is the most important source of long-term finance for listed companies in Ghana. There is also an emerging body of work linking economic growth with sound corporate governance (a central part of securities regulation) and minority shareholder protections see Raphael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishy 1999 Investor Protection: Origins, Consequences and Reform Financial Sector Discussion Paper No. 1, (Washington: World Bank), Stijn Claessens, 2005, Corporate Governance and Development World Bank Working Paper (Washington: World Bank).

5 the Federal Reserve Board, Alan Greenspan, that a financial sector that is well-rounded and does not rely entirely on the banking sector is less vulnerable to external shocks. Yet there have been few attempts to examine the effects of securities regulation, or regulatory weaknesses, on stability and growth. 4 4. This paper examines the strengths and weaknesses of securities regulatory systems worldwide with a view to a better understanding of common problems and areas of global concern. 5 In doing so, we contribute to the depth of understanding of the state of regulation of securities markets around the world and enable others to further explore the connections between securities regulation and systemic risk and securities regulation and market development. 5. Our research suggests that securities regulatory systems suffer from persistent weaknesses in a number of countries and there is an urgent need for improvement. We have used the unique set of data produced under the IMF and World Bank Financial Sector Assessment Program (FSAP) which entails a systematic assessments of regulatory systems to examine problem areas and explore the connection to income level of the country and possible regional trends. We found that a consistent theme emerges regarding the lack of ability of regulators in many countries to effectively enforce compliance with existing rules and regulation. A combination of factors, including the lack of power and authority, a lack of resources and skill, and the lack of political will has undermined the regulator s ability to effectively execute regulation. This is a particular problem in areas of increased complexity such as valuation of assets and risk management practices and internal controls requirements for market participants and trading systems. 4 One exception is Rafael LaPorta, Florencio Lopez-de-Silanes and Andrei Shleifer, 2003, What Works in Securities Law Journal of Finance, American Finance Association, vol.61(1( pages 1 32, 02. The paper concluded that there is a connection between stock market growth and strong legislation that allows effective recourse to private enforcement (tort law), but that there was no connection between growth and the presence of a strong regulator in the market. We find the paper s conclusions limited there is little discussion of the connection between strong legislation and the regulator. It seems unlikely to us that jurisdictions in which legal protections for investors are high would not also have an effective regulator. 5 Effective securities regulation relies on the existence of a sound framework, including good contract and corporate law, a fair and timely judicial process, effective protection of property rights, good accounting and audit standards and sound taxation rules. 5 We have observed that the lack of this basic framework has significantly affected the countries efforts to develop their markets and our observations are shared by others engaged in capital markets development work. We do not analyze these elements of a regulatory system, referred to as preconditions in the paper, but do make mention of them where there is a direct and noted impact on the area of regulation. Annex 3 of the IOSCO Principles of Securities Objectives and Regulation sets out a list of matters to be addressed in domestic legislation.

6 II. WHAT IS SECURITIES REGULATION? 6. Securities regulation comprises the regulation of public issuers of securities, secondary markets, asset management products and market intermediaries. Regulation is designed to address asymmetries of information between issuers and investors, clients and financial intermediaries and between counterparties to transactions; and to ensure smooth functioning of trading and clearing and settlement mechanisms that will prevent market disruption and foster investor confidence. 6 7. Regulation of public issuers is based on the principle of full, timely and accurate disclosure of relevant information to investors. Generally, securities regulators have moved away from merit-based regimes to disclosure-based regimes; that is, the regulator does not take on the role of determining whether or not an offer is too risky for investors that is a decision to be made by the investor. Rather, the regulator s role is to ensure that investors are given full, timely and accurate information to enable them to make informed decisions. For that purpose disclosure obligations are imposed on issuers both at the moment of authorization for public offering and on a continuous basis. Mechanisms are also put in place to ensure the reliability of the information provided by issuers. More recently, the regulation of issuers has highlighted the need for adequate corporate governance to ensure effective accountability of management and board members to shareholders. 8. Regulation of market intermediaries seeks to ensure that intermediaries (such as brokers, dealers and advisers) enter and exit the market without disruption, conduct their business with their clients with due care and trade fairly in the markets. The main tools for the regulation of intermediaries are licensing requirements (including prudential requirements) and market and business conduct obligations. 9. The regulation of asset management aims to ensure professional management and adequate disclosure of investments to the investors. Most regulatory systems focus on collective investment schemes, usually in the form of mutual funds or unit trust funds. Because units of collective investment schemes are investment instruments, they are bound by the same principle of full, timely, and accurate disclosure applicable to issuers generally. In addition, the operator and investment manager of the collectives investment scheme are financial intermediaries and are regulated in a manner similar to other intermediaries. 10. The regulation of secondary markets seeks to ensure the smooth functioning of the markets. Regulation of market conduct and trading seeks to ensure fair access and adequate price formation, thus preserving the market s efficiency and reputation. Regulation also aims 6 A good overview of the approach to securities regulation can be found in Bernard Black, 2001 The Legal and Institutional Preconditions for Strong Securities Markets, UCLA Law Review, vol. 48, (Los Angeles, California: University of California at Los Angeles), pp. 781 855.

7 to limit the disruptive effects that the failure of an intermediary could have on the market and, thus, is focused on ensuring that market participants settle their trading obligations in an orderly and timely manner through regulation of the clearing and settlement, and the setting of standards for risk management. 11. Responsibility for the development of the regulatory framework as well as the supervision of regulated entities is typically assigned to a public agency. The structure of the securities markets regulator may vary from a single-agency specialized in securities regulation to a unified regulator that regulates more than one sector. The regulatory framework should ensure that the regulator has sufficient independence, powers and resources to effectively regulate and supervise market participants. In most jurisdictions, selfregulatory organizations (SROs), such as exchanges, and industry associations, carry out part of the regulatory function in the jurisdiction (in many cases, SROs take on a significant role). In these cases, the regulatory framework should ensure proper oversight of SROs by the public regulator. III. DATA 12. The IOSCO Objectives and Principles of Securities Regulation constitute a valuable tool to evaluate the strengths and weaknesses of a regulatory framework. The principles cover all the regulatory issues mentioned above, which are divided into eight different categories: Principles 1 5 concern the structure and effectiveness of the regulator, Principles 6 and 7 consider the role and structure of self regulatory organizations, Principles 8 10 examine the enforcement program and activities of the regulator, Principles 11 13 examine the regulator s cooperation with domestic and international counterparts, Principles 14 16 concern the regulatory regime for issuers, Principles 17 20 concern the regulatory regime for collective investment schemes, Principles 21 24 concern the regulation of market intermediaries, and Principles 25 30 consider the regulation of the secondary markets. 13. The principles were originally published in 1998 and a methodology to assess their implementation was approved in 2003.

8 Box 1. IOSCO Objectives and Principles of Securities Regulation Objectives The three core objectives of securities regulation are: the protection of investors; ensuring that markets are fair, efficient and transparent; the reduction of systemic risk. Principles Principles Relating to the Regulator 1. The responsibilities of the regulator should be clear and objectively stated. 2. The regulator should be operationally independent and accountable in the exercise of its functions and powers. 3. The regulator should have adequate powers, proper resources and the capacity to perform its functions and exercise its powers. 4. The regulator should adopt clear and consistent regulatory processes. 5. The staff of the regulator should observe the highest professional standards, including appropriate standards of confidentiality. Principles of Self-Regulation 6. The regulatory regime should make appropriate use of self-regulatory organizations (SROs) that exercise some direct oversight responsibility for their respective areas of competence, to the extent appropriate to the size and complexity of the markets. 7. SROs should be subject to the oversight of the regulator and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities. Principles for the Enforcement of Securities Regulation 8. The regulator should have comprehensive inspection, investigation and surveillance powers. 9. The regulator should have comprehensive enforcement powers. 10. The regulatory system should ensure an effective and credible use of inspection, investigation, surveillance and enforcement powers and implementation of an effective compliance program. Principles for Cooperation in Regulation 11. The regulator should have authority to share both public and non-public information with domestic and foreign counterparts. 12. Regulators should institute information sharing mechanisms that establish when and how they will share both public and non-public information with their domestic and foreign counterparts. 13. The regulatory system should allow for assistance to be provided to foreign regulators who need to make enquiries in the discharge of their functions and exercise of their powers. Principles for Issuers 14. There should be full, timely and accurate disclosure of financial results and other information that is material to investors decisions. 15. Holders of securities in a company should be treated in a fair and equitable manner. 16. Accounting and auditing standards should be of a high and internationally acceptable quality.

9 Principles for Collective Investment Schemes 17. The regulatory system should set standards for the licensing and the regulation of those who wish to market or operate a collective investment scheme. 18. The regulatory system should provide for rules governing the legal form and structure of collective investment schemes and the segregation and protection of client assets. 19. Regulation should require disclosure, as set forth under the principles for issuers, which is necessary to evaluate the suitability of a collective investment scheme for a particular investor and the value of the investor s interest in the scheme. 20. Regulation should ensure that there is a proper and disclosed basis for asset valuation and pricing and the redemption of units in a collective investment scheme. Principles for Market Intermediaries 21. Regulation should provide for minimum entry standards for market intermediaries. 22. There should be initial and ongoing capital and other prudential requirements for market intermediaries. 23. Market intermediaries should be required to comply with standards for internal organization and operation conduct that aim to protect the interests of clients, ensure proper management of risk, and under which management of the intermediary accepts primary responsibility for these matters. 24. There should be procedures for dealing with the failure of a market intermediary in order to minimize damage and loss to investors and to contain systemic risk. Principles for the Secondary Market 25. The establishment of trading systems, including securities exchanges, should be subject to regulatory authorization and oversight. 26. There should be ongoing regulatory supervision of exchanges and trading systems which should aim to ensure that the integrity of trading is maintained through fair and equitable rules that strike an appropriate balance between the demands of different market participants. 27. Regulation should promote transparency of trading. 28. Regulation should be designed to detect and deter manipulation and other unfair trading practices. 29. Regulation should aim to ensure the proper management of large exposures, default risk and market disruption. 30. The system for clearing and settlement of securities transactions should be subject to regulatory oversight, and designed to ensure that it is fair, effective and efficient and that it reduces systemic risk. 14. We examined the IOSCO principles assessments for 74 countries, completed between 1999 and September 2007. 7 Through the FSAP and the Offshore Financial Center (OFC) program, the IMF and the World Bank carry out assessments of securities regulatory systems using the IOSCO Principles and the IOSCO Methodology. 8 In each assessment of the 7 A list of the country assessments that we reviewed is provided in Appendix I. All of them are used in the statistics; except Canada because grades were not assigned to the assessment. 8 International Organization of Securities Commissions, 1998 Objectives and Principles of Securities Regulation (Madrid: IOSCO).

10 principles, a grade of fully implemented, broadly implemented, partly implemented or not implemented is assigned. 9 These grades, along with the detailed description and commentary of the assessor, have been collated in a database at the IMF. 15. The use of the assessments as a primary dataset has inherent limitations. The principles themselves are an imprecise instrument of measurement they are broadly worded and were not, initially, designed as a measurement tool. The IOSCO Methodology and the assessor s template add a degree of direction to the assessments but the assessments remain subjective and require significant exercise of judgment on the part of the individual assessor. Assessments are carried out by one person and there were a total of 46 different assessors used. As a consequence, the consistency and quality of the assessments is somewhat mixed, 10 and this affects the usefulness of the data. In addition, the assessments are a one-time measurement of the regulatory system and are therefore limited by time. In most cases there has only been one assessment of the country (the exception is Mexico, which was assessed in 2001 and again in 2006). Further, over time assessors have worked under varying conditions some with formal guidance, including the Methodology, and some without. 16. Despite these limitations, we found a great deal of consistency in the aggregate data. Those assessments produced with the Methodology, for example, did not differ significantly from those produced before it was adopted. The data have been consistent with our own understanding based on field work and with that of our colleagues at the World Bank and other development agencies. 17. Finally, because most assessments remain confidential we have used the data on a noname, aggregate basis and have not discussed particular characteristics of any one regulatory system. 9 The grade of broadly implemented was introduced by IOSCO in 2002; this complicates the use of data comparing grades. In some cases a not applicable notation was made for a principle that did not apply (for example, in a country with no collective investment schemes, Principles 17 20 would not apply). Note also that this paper does not examine the findings related to Principle 30. Since the adoption of the IOSCO Principles and their Methodology a separate standard was develop to asses the robustness of clearing and settlement infrastructure. 10 The quality and consistency of assessments was examined in 2002. See 2002 Experience with the Assessments of the IOSCO Objectives and Principles of Securities Regulation under the Financial Sector Assessment Program IMF Board Paper (Washington, D.C.: IMF and World Bank). There is very little difference in our findings in 2002 from the findings enumerated in this paper.

11 IV. GENERAL FINDINGS 18. The assessments revealed significant weaknesses in many regulatory systems. In addition, although the intensity of the weaknesses might differ from one country to another, the findings of the assessors do show the existence of common themes. First, the lack of independence from the government and the political process appears to be the greatest challenge to the strength of the regulator, followed by a lack of legal authority and limited resources. Regulators frequently lack sufficient powers to license and de-license market operators and intermediaries and to conduct enforcement actions, and this lack of authority impedes their ability to operate an effective and credible enforcement program. Even when regulators have sufficient powers at their disposal, the conduct of enforcement in practice remains a challenge. These weaknesses are echoed in the specific topic areas where resources and authority are limited, supervision is often weak. Areas that have become increasingly complex, such as the valuation of assets in collective investment schemes, or risk management practices in markets and investment firms, appear to need the most improvement. 19. These findings are captured by the statistics, which show that for the majority of the countries, full implementation of the IOSCO Principles still remains a challenge. As illustrated in the 2006 chart in Figure 1, only four principles (1, 4, 5, and 21) show levels of full implementation 11 equal or above 80 percent. Moreover, for four principles (2, 3, 10, and 24), the levels of implementation fall below 50 percent. Overall, the key findings on weaknesses mirror the key findings of the 2002 review of the first 22 countries, as illustrated below by a comparison of overall levels of implementation in 2002 and 2006. 11 For the purpose of this section, the categories of Implemented and Broadly Implemented have been taken together.

12 Figure 1. Findings 2002 and 2006 100 90 80 70 60 50 40 30 20 10 0 2002: Implemented 1 2006: Implemented and Broadly Implemented 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 100 90 80 70 60 50 40 30 20 10 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 Principles 1-30 Source: Standards and Codes Gateway (MCM) and staff estimates. Principle 1-30 1 The 2002 data reflect Implemented only. The broadly implemented grade was introduced later. 20. We also found a high correlation between the level of income of a jurisdiction and the level of implementation of the principles. Thus, as the income increases, so does the level of implementation. Low-income jurisdictions show levels of implementation below 50 percent, lower-middle income jurisdictions show levels of implementation around 50 percent, uppermiddle income jurisdictions show levels of implementation around 60 percent, while highincome countries show levels of implementation above 70 percent. 21. The link to income is unsurprising, given the general findings elsewhere linking income to strength of institutions. We would also expect to find that wealthier countries have greater financial resources to dedicate to regulation, enabling the regulator to properly carry out the regulatory mandate. However, we note that the data does not allow us to directly link a lack of financial resources with other specific findings. 12 12 Principle 3, which measures adequacy of resources, also measures sufficiency of legal authority and capacity to perform regulatory functions. Assessments of this Principle do not provide uniform information on the level of financial resources and the impact this has on ability to function. A lack of resources at the regulator has been identified elsewhere, however, as a key challenge to developing market integrity. See Felice B. Friedman and Claire Grose and Promoting Access to Primary Equity Markets: A Legal and Regulatory Approach, World Bank, Financial Sector Discussion Series, Washington DC, May 2006.

13 Table 1. IOSCO Categories and Countries Grouped by Income 1 Category Low-income Lower Middleincome Upper Middleincome High-income OECD High-income Non-OECD Regulator 49 66 61 85 73 SRO 47 54 62 91 67 Enforcement 50 49 36 85 77 Cooperation 32 38 48 79 77 Issuers 43 47 56 83 79 CIS 67 57 72 86 75 Mkt Intermediaries 37 63 42 83 70 Secondary Mkt. 48 53 59 91 76 Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries grouped in the Fully and Broadly implementation levels.

14 Figure 2. IOSCO Categories and Countries Grouped by Income 1 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Regulator SRO Enforcement Cooperation Issuers CIS Mkt Intermediaries Secondary Mkt. Low-income Lower Middle-income Upper Middle-income High-income OECD High-income Non-OECD Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries grouped in the Fully and Broadly implementation levels. 22. Finally, regions show significant differences in the level of implementation, which, to a certain extent, are correlated with the overall income level of the region. Europe and Asia exhibit the highest levels of implementation, Western Hemisphere ranks in the middle, while the Middle East and Central Asia and Africa exhibit the lowest levels of implementation.

15 Table 2. IOSCO Categories and Countries Grouped by Region 1 Region Regulator SRO Enforcement Cooperation Issuers CIS Market Intermed. Secondary Market Africa 50 56 62 46 67 72 39 46 Asia and Pacific 82 68 67 63 77 68 64 72 Europe 74 81 72 77 68 86 69 82 Mid. East Central Asia 59 44 36 21 47 40 56 48 Western Hemisphere 64 50 52 39 61 64 60 53 Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries grouped in the Fully and Broadly Implemented levels.

16 Figure 3. IOSCO Categories and Countries Grouped by Region 1 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Regulator SRO Enforcement Cooperation Issuers CIS Mkt Intermediaries Secondary Mkt_ Africa Asia and Pacific Europe Middle East and Central Asia Western Hemisphere Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries grouped in the Fully. Statutory regulator V. SPECIFIC FINDINGS A. Quality of the Regulatory Structure 23. While in many countries securities markets started to develop without the existence of a public regulator, it is now widely accepted that the existence of a public entity charged with the regulation and supervision of the market and market participants, is key to the healthy development of markets. Regardless of the institutional structure chosen, it is important that the responsibilities of the regulator be clearly defined and that it be given an adequate level of independence, legal authority and resources to enable it to carry out its functions. 24. The assessments show that many regulators are not sufficiently independent of government and/or industry, with less than half of countries achieving a fully or broadly implemented grading. This may be because governance structures allow for interference in the regulator s daily activities, with the potential to cause regulatory forbearance, or because

17 funding or staffing mechanisms create avenues for outside control of the regulator actions. For example, some regulators cannot grant or withdraw licenses a key supervision tool instead that power remains with the Ministry of Finance. In other cases, the governing body of the regulator is controlled by a government ministry. While the trend has been toward fully independent regulators, there are still a significant number of agencies whose work is impeded by this political overshadowing which raises the potential for interference. Shortcomings in independence are regarded as connected to many other weaknesses in the regulatory system such as weak enforcement. On the other hand, many assessments also noted the need to establish additional accountability measures, such as annual reporting, financial reporting and greater transparency of decision making processes at the regulator. 80 Figure 4. Principles Relating to the Regulator 1 70 60 50 40 30 20 10 0 Principle 1. Principle 2. Principle 3. Principle 4. Principle 5. Implemented Broadly Implemented Partially Implemented Non-Implemented Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries.

18 25. A shortage of funding and legal authority is a common problem among regulators, with less than half of countries meeting or almost meeting the standard set by IOSCO. Many regulators still lack a stable and adequate level of funding, in particular in countries where funding stems from the state budget. In many countries, the impact of inadequate and uncertain funding on the skill level at the regulator is compounded by a requirement that the regulator pay staff at the public employee pay scale, thereby limiting the regulator s ability to recruit qualified personnel and thus its capacity to discharge its functions properly. In some jurisdictions, there is also a shortage of personnel with the necessary expertise in the country as a whole (for example, qualified accountants and auditors are in short supply in many places). In addition, in some jurisdictions the regulator still lacks sufficient licensing power, which limits its ability to verify the fitness and propriety of market participants, and also investigative and enforcement power, which hinders its ability to supervise compliance and enforce the securities laws and regulations. Self-regulatory organizations 26. A unique feature of securities regulatory systems is the widespread use of SROs to carry out regulatory functions. The term SRO is used to describe a variety of institutions (exchanges, trade associations, private agencies, etc.), and in the context of the IOSCO Principles is given a broad definition: any organization other than the statutory regulator that is responsible for regulation. The use of self-regulation varies widely, although most countries rely upon it to some extent, particularly for market oversight and regulation of intermediaries. In many countries, a stock exchange is the SRO and regulates listed companies and trading. In a few countries, for example, the U.S., Canada, and Japan, a separate private agency is responsible for regulation of intermediaries, including designing and monitoring of prudential standards and business conduct. 27. The assessments evaluate the adequacy of oversight of SROs by the statutory regulator. The reports found that weaknesses in oversight of self-regulation are widespread; only a quarter of jurisdictions were considered fully compliant with the standard. The most pervasive issue is a lack of inspection programs for SROs, which, in turn, was due to a lack of resources and capacity at the regulator. In a number of countries, there was very little active oversight at all. Many assessors commented on weaknesses in governance structures at self-regulatory organizations, but views of assessors on what constitutes an appropriate structure varied widely. In some jurisdictions, there was an overlap of responsibilities between the regulator and the SRO(s) that resulted in inefficiencies or a lack of activity in the particular area. Many assessors raised concerns regarding the handling of SRO conflicts of interest (for example, the treatment of self-listing at an exchange or the fair treatment of members).

19 B. Effectiveness of Enforcement 28. Enforcement in this context refers to the agency s ability to both affect compliance with regulation (through active supervision) and its ability to bring an action against a person or entity that has violated regulations. The lower grades in this area reflect weaknesses in enforcement powers and more importantly the inability of many regulators to carry out an effective enforcement program. An effective regulator must have the ability to obtain all necessary information from regulated entities in a timely fashion, both in the course of supervision (such as in inspections) and in extraordinary circumstances (such as in investigations). Regulators must also have the ability to penalize regulated entities that do not comply with rules either in the course of supervision or as the result of a proven violation of the rules. 29. The assessments noted than in some jurisdictions regulators lack comprehensive investigative and enforcement powers (such as the ability to enter premises to collect information or to compel testimony from individuals). They also showed that many regulators lack the authority to impose administrative sanctions, and therefore had to rely on the criminal authorities for enforcement purposes which hinder their credibility and effectiveness. 30. However, the main problem in enforcement relates to the actual capacity of the regulator to implement adequate supervisory programs, as well as to appropriately use its disciplinary powers. Roughly 50 percent of the countries ranked either partly and not implemented in an assessment of the use of their enforcement powers. Assessors highlighted that in many countries on-site inspections are not a regular part of the supervisory program of the regulator, and the problem is particularly acute concerning exchanges. Finally, in some countries the supervisory programs were deemed adequate, but disciplinary powers were used very scarcely, which hinder the credibility of the regulator. A lack of skilled personnel to conduct both supervisory and enforcement actions was perceived by most assessors to be a consistent problem in many jurisdictions.

20 Figure 5. Principles for the Enforcement of Securities Regulation 1 60 50 40 30 20 10 0 Principle 8. Principle 9. Principle 10. Implemented Broadly Implemented Partially Implemented Non-Implemented Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries. 31. The poor quality and ineffectiveness of the judiciary system also negatively impacts enforcement efforts in a number of jurisdictions, primarily in emerging market and developing countries. While a supportive judicial environment is a pre-condition to effective regulation, rather than part of the IOSCO standard, a number of assessors noted that the lack of a fair and impartial judiciary that could arbitrate disputes and impose or enforce sanctions within a reasonable timeframe, undermined both the credibility and effectiveness of securities regulation. Cooperation 32. In an increasingly globalized market it is necessary that regulators be able to share public and non public information with one another. While progress has been made, the assessments show that roughly 40 percent of the jurisdictions still encounter problems in their ability to share public and non public information with domestic and foreign counterparties.

21 Figure 6. Principles of Cooperation in Regulation 1 60 50 40 30 20 10 0 Principle 11. Principle 12. Principle 13. Implemented Broadly Implemented Partially Implemented Non-Implemented Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries. C. Regulation of Public Issuers 33. The quality of disclosure by issuers of securities to investors, and the fair treatment of minority shareholders are key to the credibility of a market place. The market (investors, intermediaries, analyst, etc.) must be able to rely on the information given by management of issuers in order to appropriately value securities this includes financial information, business plans and disclosure of ownership interests and conflicts of interest. This information must be timely and must be equally accessible to all shareholders simultaneously. Minority shareholders must be given adequate voting rights and notice of meetings and corporate changes, access to information regarding insider transactions and dealings with the company, and fair treatment in take over bids and related party transactions. These protections are particularly important in jurisdictions with concentrated ownership of public issuers, which describes the majority of emerging market and developing countries.

22 34. Few countries received a failing grade on their disclosure regimes. Most jurisdictions have adequate disclosure in place for initial offerings, requiring that a prospectus complete with audited financial statements be given to investors prior to the purchase of the offering. However, in many countries there is a lack of proper review of prospectus disclosure by the staff of the regulator or exchange, and a lack of skill at the regulator in ensuring that disclosure is meaningful to investors. In these jurisdictions, disclosure may strictly meet criteria set out in legislation but fail to convey to investors and others an adequate understanding of the business plan, business risks and financial condition of the issuer. 35. In a number of countries there was also a lack of continuous disclosure requirements that is requiring material events to be immediately disclosed to the market, and annual and quarterly reporting. In many developing countries, continuous disclosure requirements either did not exist or were not practically enforced in the case of companies that did not trade on an exchange. A number of assessments concluded that disclosure, particularly of price sensitive information, was not timely and therefore did not provide investors with sufficient transparency.

23 Figure 7. Principles for Issuers 1 60 50 40 30 20 10 0 Principle 14. Principle 15. Principle 16. Implemented Broadly Implemented Partially Implemented Non-Implemented Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries. 36. Most jurisdictions had basic shareholder meetings, notice and voting provisions set out in company law as well as securities regulation. Many, however, had insufficient rules with respect to changes of control (takeover bid and mergers) and related party transactions. Insider transactions in many countries are not reported with sufficient speed to ensure transparency to shareholders. In a number of developing and emerging market countries, the reporting of insider transactions is made to the regulator, but not the public or investors. Following on the theme of a weakness in enforcement of requirements regulators in many countries were regarded as putting insufficient skill and resource into ensuring that the standards were actually applied. D. Regulation of Collective Investment Schemes 37. The regulation of collective investment schemes (CIS), including mutual funds, aims to ensure adequate disclosure to investors, appropriate valuation of fund units and the safeguarding of investor s assets from the operator of the fund. CIS are popular retail investments and therefore attract a high degree of customer protection regulation. They are also an important force in the market, and therefore the accurate valuation of their assets may

24 have systemic importance. Many of the countries assessed had nascent CIS industries future assessments will reflect a fast-growing industry, particularly in emerging market countries. 38. While the data show a high level of implementation of the IOSCO standards for CIS, the comments of the assessors suggest that important weaknesses remain in the legal and regulatory framework, as well as in the supervisory arrangements. This outcome may be a consequence assessors focus on the legal and regulatory framework rather than on its actual implementation, because in many jurisdictions the laws regulating collective investment schemes were relatively new, and because in developing and emerging market countries the CIS industry was very small and underdeveloped. Finally, while compliance monitoring and enforcement is said to be weak in these jurisdictions, lack of enforcement activity may not be sufficiently taken into account in assessing this area. 39. Comprehensive licensing requirements applicable to CIS managers are in place only in about half of the jurisdictions assessed and some emerging and developing markets still lack a licensing regime for CIS managers altogether. Licensing requirements are not comprehensive in many countries: while they usually include a minimum level of capital, other requirements aimed to verify that the entity has the technical and operational capacity to manage CIS are not in place nor are fit and proper requirements for certain controlled functions. Given the importance of licensing as a supervision tool through which standards are set and applied, these shortcomings in licensing regimes are significant. 40. The assessments noted deficiencies in CIS oversight by the regulator. Assessors found that in many jurisdictions licenses are approved without a thorough examination of the CIS manager s technical and operational capabilities to manage funds, and the licensing process does not include an on-site visit. In many jurisdictions, the regulator has not included on-site inspections as a regular part of their on-going supervisory programs. In some of these cases, the regulator is relying on the depository to conduct oversight of the CIS manager; however assessors concluded that, in practice, the depositories were not adequately fulfilling their role and should not be relied on so extensively. 41. Many jurisdictions still lack a comprehensive set of business and market conduct rules for CIS managers, including the regulation of conflict of interest. Assessors also noted that in some jurisdictions where bank platforms were used to market and place CIS, bank personnel was not subject to the same market conduct rules, nor were they supervised with the same intensity as the personnel of the CIS manager. Without appropriate market conduct and business conduct rules, investors are at risk of mis-selling and other abuses. Development of CIS markets will depend on, among other things, the ability of CIS to maintain investor confidence and properly manage conflicts of interest addressed by such rules.

25 Figure 8. Principles for Collective Investment Schemes 1 80 70 60 50 40 30 20 10 0 Principle 17. Principle 18. Principle 19. Principle 20. Implemented Broadly Implemented Partially Implemented Non-Implemented Source: Standards and Codes Gateway (MCM). 1 Numbers in the table represent the average percentage share of the applicable and assessed principles for all countries. 42. Although this contradicts the grading data, the assessments described important weaknesses in protection of customer assets. Most of the jurisdictions assessed have adequate regulations concerning the legal form and structure of the CIS, but the assessments noted an insufficient separation of customer assets from those of the CIS manager s. In many countries, there are still no rules requiring that separation, which is key to protecting customers from the financial dissolution or bankruptcy of the manager. In other jurisdictions, the rules do exist, but implementation in practice has proven to be more challenging. For example, in jurisdictions where custody by a third party is mandatory, the custodian which in most cases is a bank is usually part of the same business group as the fund manager; which weakens investor protection. 43. While in the majority of the countries there are certain disclosure obligations for the public offering of CIS, many weaknesses remain. In most countries, fund managers are required to prepare a prospectus with information on the fund manager and the CIS; however many assessors expressed concern regarding the quality of that disclosure, mainly the analysis of risks which they found insufficient as well as the language and format used for the disclosure, which they believed need to be more investor friendly. In addition, assessors

26 noted that in many jurisdictions, CIS managers were not required to keep the information included in the prospectus up-to-date, or to inform the market on the occurrence of material events. In some jurisdictions, the regulatory review of the prospectus is very limited. Finally, in many jurisdictions, there are still problems of regulatory arbitrage between different types of CIS, as well as between CIS and insurance products that are similar to CIS, and which are not subject to the same standards of disclosure and supervision. 44. Valuation of illiquid assets is the key challenge for the industry and the regulator. This problem is particularly acute for developing markets where the majority of the securities available for investment are illiquid, and thus the prices derived from the trade carried out in the market might not be a reliable indicator of their true market value. Difficulties in valuation of some assets make it very difficult for CIS managers to value the CIS portfolio, as a whole. Jurisdictions have come up with different ways to address this problem, including subjecting valuation of illiquid assets to a third-party validation, and the development of a valuation methodology for the whole market with the involvement of the regulator. In addition, many assessors noted as a problem the lack of clear rules regarding how to proceed in cases where there have been errors in the pricing process. In some jurisdictions, there are explicit provisions that require fund managers to notify the regulator of pricing errors that reach certain thresholds, as well as to compensate investors for any loss arising from the error with their own capital; however in many jurisdictions regulations are silent. E. Regulation of Market Intermediaries 45. The regulation of market intermediaries has three main objectives: to protect client assets from insolvency of the firm or appropriation by the firm or its employees; guard against defaults and sudden disruption to the market, either through sudden insolvency or settlement failure; and, to ensure that intermediaries are fair and diligent in dealing with their clients. Regulation, therefore, sets licensing standards (limiting the market place to those with sufficient resources and qualification), prudential standards (protecting against sudden financial failure), internal controls and risk management standards (reducing the possibility of default or appropriate of client assets), and business conduct rules (ensuring proper handling of client accounts). 46. The assessments found regulation of intermediaries to be an area of weakness. While licensing standards and a supervisory framework may be in place, many regulators lack the skilled staff to oversee market intermediary activity effectively or to set detailed standards for internal controls, risk management or adequate prudential requirements. This lack of indepth understanding prevents regulators from executing effective inspections and examinations and from detecting potential insolvencies. The regulation of market intermediaries in jurisdictions with these weaknesses, takes on a form over substance character, with formal reporting and inspection programs that do not yield results.